2 Insider-Buying ETFs: Very Different Returns

Insider-sentiment ETFs are designed around the idea that top employees within a company have a better view of its fundamentals. If they are buying their company’s own stock, it probably means the company is in good fundamental health, or the stock is a good value buy.

It’s almost like investing with an insider track. And that’s what investors like about these types of funds.

There are many buyback ETFs that largely fit that goal—funds like the $1.7 billion PowerShares Buyback Achievers (PKW | A-78), which own stocks from U.S. firms that repurchased at least 5% of their outstanding shares in the previous 12 months.

Same Index, Different Results

But there are two insider-sentiment ETFs that go head-to-head, each tracking a Sabrient index, and each delivering very different portfolios and returns over time.

The Guggenheim Insider Sentiment ETF (NFO | C-61) is the oldest of the two, launching roughly 10 years ago, and gathering about $88 million in assets to date. The fund tracks the Sabrient Insider Sentiment Index, a benchmark of 100 U.S. stocks drawn from 4,000 eligible stock that are selected by increases in earnings estimates and positive buying trends of corporate insiders.

NFO essentially buys when top executives are buying—based on public filings—and then looks for confirmation on forward earnings estimates “for a reality check,” according to ETF.com’s fund report. The fund is equal-weighted, and it tilts toward small and micro-cap names, increasing its risk profile relative to the market.

Other Uses Different Index

The Direxion All Cap Insider Sentiment Shares (KNOW | B-76) tracks the Sabrient Multi-Cap Insider/Analyst Quant-Weighted Index, comprising 100 companies chosen from the S&P 1500 based on trading by corporate insiders such as directors and officers—half of the portfolio is weighted exponentially; half is equal-weighted.

KNOW also looks for earnings quality, and the portfolio tilts toward midcaps, while large-caps are underrepresented. The fund, which came to market in December 2011, has $146 million in assets.

From a cost perspective, both NFO and KNOW charge 0.65% in expense ratio, but NFO trades with an average spread twice the size of KNOW’s, at 0.22%.

If these funds attempt similar outcomes for similar cost, their returns are not similar at all. Consider their two-year performance in the chart below:

That performance difference hinges on the small differences in approach. David Brown of Sabrient Systems recently spoke about what makes NFO and KNOW different, from an index level. You can read the full interview here, but some highlights include:

Sector Exposure And Turnover Limitations

“Two key differences between the two Sabrient indexes underlying those ETFs are the limitation on sector concentrations and turnover,” Brown said. “NFO enforces strict limits of 20% from any given business sector and 10% from any given subindustry. KNOW has no limits at all. KNOW can essentially take larger sector bets, whereas NFO ensures broad diversification.”

“In addition, NFO has a 25% turnover limitation on each quarterly rebalance to reduce transaction costs, while KNOW has no turnover limitation at all, and it rebalances monthly, which can lead to faster rotation in sector weightings,” he added.

Little Overlap In Portfolio HoldingsPortfolio construction is straightforward for NFO, and pretty active and complex for KNOW.

“The two underlying indexes both select from a range of capitalizations from small to large, and both employ the same basic underlying Insider/Analyst model to identify 100 stocks. However, there are significant differences in how we arrive at the final portfolios,” said Brown.

“For NFO, we start with a broad universe of over 4,000 eligible stocks that we track in our database, and the Insider/Analyst model is run to identify the 100 highest-ranked stocks, subject to the sector and turnover limitations. All 100 stocks are equally weighted. Overall, the process is pretty straightforward.

“On the other hand … KNOW’s selection process is more complex and active. For KNOW, we start by selecting only from the S&P 1500, but we eliminate the bottom 20% of stocks as ranked by our Earnings Quality Rank, leaving about 1,200 eligible stocks. We then run the Insider/Analyst model to identify the 100 highest-ranked stocks for the final portfolio—again, with no limits on sector concentrations or turnover.

“Next, we apply our Defensive Equity model to rank these 100 stocks according to their tendency to outperform during periods of market weakness, and each stock’s relative ranking is used to determine a modified exponential weighting.

“KNOW is more complex, active, concentrated and unrestrictive in its search for the most compelling stocks for the coming month,” said Brown.

“Although some investors prefer such an aggressive approach, others prefer the process underlying NFO, as it is more conservative regarding turnover, transaction costs and diversification,” he added.

Why Own Either ETF?

To investors, these type of strategies are about enhancing potential returns by owning companies and sectors that show relatively strong insider sentiment, positive earnings outlook and are, therefore, more likely to outperform the market.

Long term, that has not only been the case, but, this year to-date, that has transpired, as both NFO and KNOW are outperforming the SPDR S&P 500 (SPY | A-99), as the chart below shows: